UGBS 205 Fundamentals of Accounting Methods PDF

LET’S LEARN BUSINESS ADMINISTRATION 2020 UGBS 205: FUNDAMENTALS OF ACCOUNTING METHODS Features: DARKO KWANBENA EMMANUEL ❖ COMPREHENSIVE NOTES AND...

LET’S LEARN BUSINESS ADMINISTRATION 2020 UGBS 205: FUNDAMENTALS OF ACCOUNTING METHODS Features: DARKO KWANBENA EMMANUEL ❖ COMPREHENSIVE NOTES AND (DKE) & HARRISON KORBLA ILLUSTRATIONS ❖ SOLVED EXERCISES AND PAST SETSOFIA (HKS) EXAMINATION QUESTIONS LET’S LEARN BUSINESS ADMINISTRATION ❖ UNSOLVED EXERCISES AND PAST 7/14/2020 EXAMINATION QUESTIONS UGBS 205: FUNDAMENTALS OF ACCOUNTING METHODS 07/14/2020 ACKNOWLEDGEMENT We will like to thank God Almighty for granting us the knowledge and strength to provide this book. My brother and I wish to express gratitude to Mr. Ben of Let’s Learn Business Administration and all admins for the approval, support and encouragement he gave us to compile this book. Mention to be made also to all administrators of LET’S LEARN BUSINESS ADMINISTRATION for their support, encouragement, most of all their time wasting. Our profound gratitude goes to all members of LET’S LEARN BUSINESS ADMINISTRATION for accepting us to you through the accounting. We really appreciate for your solicitudes. It is unfortunate that the expression of appreciation no matter how extensive, is always incomplete and the above is no exception. DEDICATION We dedicate this book to all student studying BSc. Administration and Bachelor of Arts in Administration in University of Ghana, Legon. DARKO KWANBENA EMMANUEL (DKE) & HARRISON KORBLA SETSOFIA (HKS) 1 UGBS 205: FUNDAMENTALS OF ACCOUNTING METHODS 07/14/2020 TABLE OF CONTENT PAGES 1. NATURE OF ACCOUNTING 2. ACCOUNTING CONCEPTS AND CONVENTIONS 3. THE ACCOUNTING EQUATION 4. RECOGNITION MEASUREMENT OF ELEMENT OF FINANCIAL STATEMENTS 5. DOUBLE ENTRY PRINCIPLES 6. BOOKS OF ORGINAL ENTRY 7. CONTROL ACCOUNT 8. BANK RECONCILIATION STATEMENT 9. CAPITAL EXPENDITURE AND REVENUE EXPENDITURE 10. DEPRECIATION OF TANGIBLE NON-CURRENT ASSETS 11. ADJUSTMENTS FOR FINANCIAL STATEMENTS DARKO KWANBENA EMMANUEL (DKE) & HARRISON KORBLA SETSOFIA (HKS) 2 UGBS 205: FUNDAMENTALS OF ACCOUNTING METHODS 07/14/2020 CHAPTER 1 THE NATURE AND FUNCTIONS OF ACCOUNTING DEFINITION AND MEANING OF ACCOUNTING Universally, Accounting is simply the financial language of business entities and other organizations. It is used to assess the financial well-being of an organization. Accounting be defined as the collection, recording, evaluation and communication of economic events, qualified in monetary terms. Accounting or Accountancy is interested in and deals with only matters or information that can be quantified in monetary terms. In this current era, Accounting is defined as “the process of identifying, measuring and communicating information about an entity to permit informed judgements and decisions by users of the information”. (AAA,1966). In other words, Accounting is the amount of recording, classifying and summarizing in a significant manner and in terms of money, transactions and event which are in part at least, of a financial character and interpreting the results thereof. (AICPA,1961). FUNCTIONS OF ACCOUNTING DEFINITION The analysis of this definition by the AICPA brings out the functions of accounting which includes recording, classifying, summarizing, interpreting and communicating. Recording: it is concerned with ensuring that all business transactions that are quantified in monetary terms are recorded. The recording is done in the Journal. Classifying: this grouping the financial data into similar characteristics or nature. For instance, all goods bought for resale are grouped together at one place and treated differently on whether the goods where bought with cash or on credit. The classification is done in the book as Ledger. DARKO KWANBENA EMMANUEL (DKE) & HARRISON KORBLA SETSOFIA (HKS) 3 UGBS 205: FUNDAMENTALS OF ACCOUNTING METHODS 07/14/2020 Summarizing: this is done to make the information clarified, understanding and simple. This process leads to balancing of accounts, extraction of the Trial balance, preparation of income statements and balance sheet. Dealing with financial transactions: Financial transactions are often referred to as “economic events” where there has been an exchange of something of value between two or more entities. Accounting transactions can only be recorded if they can be quantified in monetary term which are of a financial character. Analyzing and Interpreting: The financial data are analyzed and interpreted for the users in making effective decisions. Communicating: After the information have been analyzed and interpreted, it has to be communicated in a proper form and manner to the appropriate users. PURPOSE / OBJECTIVE OF ACCOUNTING ( C2PEAR) 1. To know the change of capital structure. 2. To provide relevant information to know the change in our resources. 3. To provide information to determine profit or loss. 4. To provide useful financial information about economic resources to the decision makers. 5. To provide information about an organization’s accounting policies such as method of stock valuation, depreciation, etc 6. To provide information to meet the legal regulatory requirements. BOOKKEEPING AND ACCOUNTING Bookkeeping is the process of recording daily transactions in a consistent way. Bookkeeping is simply referred to as making records of business transactions. It consists of; ❖ Recording transactions ❖ Posting ❖ Producing invoice DARKO KWANBENA EMMANUEL (DKE) & HARRISON KORBLA SETSOFIA (HKS) 4 UGBS 205: FUNDAMENTALS OF ACCOUNTING METHODS 07/14/2020 ❖ Maintaining ledgers IMPORTANCE OF BOOKKEEPING (PRICO) 1. It facilitates the preparation of financial statements. 2. A permanent record is made for all transactions. 3. It helps to keep track of all information relating to debtors and creditors of the business entity. 4. It helps the management to control and safeguard the business assets. 5. Failure to maintain records can be an offence in case of bankruptcy. DIFFERENCE BETWEEN BOOK-KEEPING AND ACCOUNTING The difference between bookkeeping and accounting is that bookkeeping is concern with information gathering (data collection) while Accounting goes further to analyze and interpret this information for decision making. BUESINESS ENTITIES A business is an organization in which basic resources (inputs) are assembled to provide goods or services (outputs) to customers.in other words, business is an organization formed to produce goods and services to satisfy the needs of consumers at a profit. THE TYPES OF BUSINESS UNDER PROFIT MOTIVE Profit Oriented Organizations: Businesses set up with the sole aim of making profits. Governmental Organizations: Public sector entities set up to provide public goods and services. DARKO KWANBENA EMMANUEL (DKE) & HARRISON KORBLA SETSOFIA (HKS) 5 UGBS 205: FUNDAMENTALS OF ACCOUNTING METHODS 07/14/2020 Non-Governmental Organizations: Organizations set up to achieve other objectives in the society and not for profit. THE TYPES OF BUSINESS UNDER ACTIVITIES Manufacturing Business: Changing basic inputs into goods that are sold to customers. Merchandising Business: Purchase goods from other businesses and sell to customers (either wholesaling or retailing). Service Business: Provides services rather than goods to customers. THE TYPES OF BUSNIESS UNDER OWNERSHIP Sole proprietorship Owned by a single individual. Least regulated – registration at the Registrar General Department. Characteristics of Sole Proprietorship: Easy formation, Less expenses to operate, All profits and losses, unlimited liabilities, lacks of perpetual succession, limited source of funds, difficulty in ownership transfer, etc. Partnership Formed by 2 or more individuals. Operate with partnership agreements (formal or informal). Regulated by the private Incorporated Partnership Act (Act 152) of 1962. Partners could be dormant or active partners. Characteristics of Partnership: Polling of skills and Resources, severally and joint liable, share profits and losses, unlimited liabilities, lacks perpetual succession, limited source of funds, difficulty in ownership transfer, etc. Company Owned by one or more persons (shareholders). Regulated by Companies Code and other statutes. Formation requires at least 2 directors. DARKO KWANBENA EMMANUEL (DKE) & HARRISON KORBLA SETSOFIA (HKS) 6 UGBS 205: FUNDAMENTALS OF ACCOUNTING METHODS 07/14/2020 Public or private. Limited (by shares or guarantee) or unlimited. Characteristics of Company: legal separate entity, separation of ownership and management, share (dividends) / re-invest profits, limited liabilities, perpetual succession, wide access to raise funds, ease in ownership transfer. WHY BUSINESS NEED ACCOUNTING INFORMATION Sole proprietorship Tax collecting purposes. Lending purposes. Business valuation purposes. Partnership Fairness in sharing of partnership profits. Tax purposes Lending / financing purposes. The purpose of admitting other partners into the partnership. Companies To determine funding needs for the company. To maintain proper inventory levels. To gauge actual performance for the year and understand the basic costs of company operations. FINANCIAL STATEMENTS The main objective of business entity is to make profits for its owners. To accomplish this objective a business entity must undertake some activities or engage in some kind of operations. Examples including buying and selling of goods, manufacturing of goods for sale or provision of services for revenue. It is very essential to keep proper records of transactions that arise from these activities in order to provide the necessary financial and accounting information for the benefit of stakeholders. DARKO KWANBENA EMMANUEL (DKE) & HARRISON KORBLA SETSOFIA (HKS) 7 UGBS 205: FUNDAMENTALS OF ACCOUNTING METHODS 07/14/2020 The purpose of financial statement is to provide information about the performance, the financial position and the changes in the financial position of the business entity. This information is very useful making effective economic decisions by the users. The financial statement which contains such information of the business entities includes income statement, balance sheet, cash flow statement, value added statement. INCOME STATEMENT (trading and profit or loss accounting) This is the financial statement prepared to determine the performance of a business entity. That is it determines whether profit or loss has been made by the reporting entity in the financial year under consideration. It provides business owners and other users the information that helps them to predict the amount and the uncertainty of the future cash flow. This is because it enables users to evaluate the past performance of the business entity and this could be used to project the future outcome. BALANCE SHEET Balance sheet is a statement which shows the financial position of the business entity. It contains the assets, capital and liabilities of the business entity. CASH FLOW STATEMENT This is the statement prepared to show cash resources that come to the business and how these cash resources are used during the period. In other words, is shows all the inflow and outflow of cash over the period of time. The main function of the cash flow statement in financial reporting is determine how much funds the business generated from the sources during the reporting period and how much funds were disbursed. Note: There are other financial statements like value added statement and so on which need to be discussed but for our level we will limit ourselves to the first three statements discussed above. THE ACCOUNTING CYCLE/PROCESS The process of preparing financial statements may be considered as a cycle, which can be depicted diagrammatically as follows: DARKO KWANBENA EMMANUEL (DKE) & HARRISON KORBLA SETSOFIA (HKS) 8  UGBS 205: FUNDAMENTALS OF ACCOUNTING METHODS 07/14/2020 Collection of source Documents Interpretation of Financial Recording of transaction in the statement books of original entry/Journals Preparation of Financial Postings to the ledger book and statements balancing of accounts Extraction of trial balance LIMITATIONS OF FINANCIAL STATEMENT 1. It does not record vital information which lack financial character. 2. It does not provide detail analysis of information. 3. It permits alternative treatment which sometimes makes comparison difficult. 4. It does not disclose the present value of the business. USERS OF ACCOUNTING INFORMATION AND THEIR INTERESTS. MANAGEMENT: These are the people who manage the operations of the reporting entity and therefore have the responsibility for the preparation of the financial statements. ❖ To know the profitability of the business. ❖ To measure the performance of the business. ❖ To assess the returns on their investments. ❖ To assess the assets and liabilities of the business. EMPLOYEES: Employees are those working in the organization. They are concerned with the ability of the management to pay wages, salaries and commission when due. ❖ To know the profitability of the business. DARKO KWANBENA EMMANUEL (DKE) & HARRISON KORBLA SETSOFIA (HKS) 9 UGBS 205: FUNDAMENTALS OF ACCOUNTING METHODS 07/14/2020 ❖ To judge their job security or continued employment. ❖ To agitate for better pay and working condition. SHAREHOLDERS: They are those who have contributed capital for the running of the business. Thus, they are the owners of the business organization. ❖ To know the growth, survival and profitability of the business. ❖ To know the value of shares and the dividend to pay them. ❖ To enable them to decide whether to continue, expand or liquidate the business. ❖ To know whether investing is worthwhile and whether they will get a return on their investment. SUPPLIERS: They are those who provide goods and services to the business for cash or on credit basis. Those who provide goods and services on credit basis are known as trade creditors. Trade creditor sell goods and wait for an agreed time before payment is made by the business. ❖ To know the profitability of the business. ❖ To know the liquidity of the business. ❖ To know the ability of the business to pay its debts and how long it will take to do that. ❖ To assess the asset s and liabilities of the business. CUSTOMERS: These are the people who purchase goods from the business entity. Most often customers do buy on credit and they are called Trade debtors. They are interested in the information ❖ To assess the fairness of pricing policies of the business organization. ❖ To know whether the business is financially sound so as to have confident in it. ❖ To certain whether the business will be a secure source of supply. GOVERNMENT AGENCIES: The government agencies and the public authorities are interested in the allocation of resource. This means that the activities of the business organization interest them. ❖ To measure the performance the business entity. ❖ To know the revenue, expenditure and expenses of the business organization. ❖ To know the effects of its policies on the businesses and the economy. ❖ To know how to collect tax from businesses or companies. QUANTITATIVE CHARACTERISTICS OF ACCOUNTING INFORMATION For the accounting information to be useful to the users it must possess some certain characteristics. These are characteristics are considered as quantitative characteristics. The characteristics of useful accounting information are as follows: DARKO KWANBENA EMMANUEL (DKE) & HARRISON KORBLA SETSOFIA (HKS) 10 UGBS 205: FUNDAMENTALS OF ACCOUNTING METHODS 07/14/2020 (i) Relevance: - The accounting information should be relevant to the needs of the users to enable them evaluate the performance of the business and draw conclusion. (ii) Understandability: - The information should be in a form which is understandable by user groups. Thus, all material matters should be disclosed without unnecessary complex details. (iii) Reliability: - The accounting information should something that can be depend on by the users in their decision making. Thus, the information should be reliable so that the conclusion drawn may be true and fair. (iv) Comparability: - The accounting information should be comparable with other similar business from one period to another, this means the information should be comparable within and outside the organization. (v) Timeless: - The information should be prepared and presented to the users on time. Thus, the financial statements of the businesses should be published as soon as possible after the year ends. SUBFIELDS IN ACCOUNTING Financial Accounting: - Is defined by the American Accounting Association (A.A.A) as “the process of identifying, measuring and communicating information about an entity to permit informed judgements and decisions by users of the information”. Cost Accounting: - Is defined as part of management accounting which established budgets and standards cost, actual cost of operations, processes and department and analyzing of variances and profitability and social use of funds. Management Accounting: - Management accounting is an integral part of management; such accounting concerned with identifying, presenting and interpreting information for the formulating of strategies, planning and controlling the activities, decisions making and optimizing the use of resources. Public Sector Accounting: - Is the process of accounting for financial activities of the government institutions and organizations at a particular period. Identification of sources and used of resources for management entities. Taxation: - Proper accounting for the incomes and expenditures of taxable entities. Auditing: - Giving independent assurance as to the true and fair view of financial reports. DARKO KWANBENA EMMANUEL (DKE) & HARRISON KORBLA SETSOFIA (HKS) 11 UGBS 205: FUNDAMENTALS OF ACCOUNTING METHODS 07/14/2020 Difference between financial Accounting and Cost Accounting Financial Accounting Cost Accounting 1. It reports to outsiders of the organization 1. It reports to insiders of the organization. such as supplier, owners, agencies etc. Example, management. 2. It looks at the performance of the 2. Its records are kept to know the actual or business as a whole. estimated costs of an activity. 3. It must comply with Generally Accepted 3. It does not comply with GAAP. Accounting Principles (GAAP). 4. Financial accounting deals with only 4. Cost accounting deals with both monetary items of monetary value only. and non-monetary values. 5. Cost accounting is neither governed by 5. The preparation of financial statements is legal enactments. governed by legal enactments. Difference between Financial Accounting and Management Accounting Financial Accounting Management Accounting 1. Information is prepared by conforming to 1. Information prepared does not conform to the generally acceptable accounting any GAAP. principles (GAAP). 2. Accordingly, the cost of recording 2. Accordingly, the cost of record keeping keeping is necessity. needs to be justified. 3. Are mainly concerned with profit. 3. Are mainly concerned with cash flow, profit and business management generally. 4. Objectives and use of financial accounting are not defined by 4. Objectives and uses of the management management. accounts can laid down by management. 5. Are mainly historical costs. 5. Are regularly concerned with predictions. TUTORIAL QUESTIONS 1. (a) what is accounting? (b) Explain four functions of accounting. (c) Mention five objectives of financial accounting. DARKO KWANBENA EMMANUEL (DKE) & HARRISON KORBLA SETSOFIA (HKS) 12 UGBS 205: FUNDAMENTALS OF ACCOUNTING METHODS 07/14/2020 2. (a) What is bookkeeping? (b) Explain five importance of bookkeeping. (c) What is the difference between bookkeeping and accounting? 3. (a) Write short notes on the following terms; i) Cash flow statement ii) Income statement iii) Balance sheet (b) Give three limitations of financial statement. 4. Sate and explain the quantitative characteristics of good financial accounting information. 5. Identify six users of accounting information and explain the interest of each user. 6. (a) Write four difference between Financial Accounting and Cost Accounting. (b) State and explain any four subfields in Accounting. “The expert in anything was once a beginner” DARKO KWANBENA EMMANUEL (DKE) & HARRISON KORBLA SETSOFIA (HKS) 13 UGBS 205: FUNDAMENTALS OF ACCOUNTING METHODS 07/14/2020 CHAPTER 2 ACCOUNTING CONCEPTS, PRINCIPLES, BASES AND STANDARDS. INTRODUCTION Prior to 1929, no group being it public or private was responsible for accounting standards. After the 1929 stock market crash, the securities and Exchange Act of 1934 was passed. This resulted in the US. Securities and Exchange Commission (SEC) supervising public companies. The Securities and Exchange Commission (SEC) designated the Financial Accounting Standards Board (FASB) as the organization responsible for setting accounting standards for public companies in US. CONCEPTUAL FRAMEWORK In accounting, a conceptual framework can be system of ideas and objectives that lead to the creation of a consistent set of rules and standards. Conceptual framework is a statement of principles which provide generally accepted guidance for the development of new reporting practices and for challenging and evaluating the existing practices. Specifically, in accounting, the rule and standards set the nature, function and limits of financial accounting and financial statements. These main reasons for developing an agreed conceptual framework are that it provides; ✓ Framework for setting accounting standards ✓ Basis for resolving disputes ✓ No repetition of Fundamental principles. INTERNATIONAL ACCOUNTING STANDARDS BOARD (IASB) The international Accounting Standards Board (IASB) is the framework for the preparation and presentation of Financial statement in 1989. This referred to as its conceptual framework. The IASB bases its financial reporting standards on the conceptual framework that is adopted in 2010. The conceptual framework was developed by IASB and it lays down the basic concepts and principles that act as the foundation for preparation and presentation of the financial statements. The framework is also used as guide to develop or improve standards and to resolve any accounting conflicts. Note that the conceptual framework is not an accounting standard in DARKO KWANBENA EMMANUEL (DKE) & HARRISON KORBLA SETSOFIA (HKS) 14 UGBS 205: FUNDAMENTALS OF ACCOUNTING METHODS 07/14/2020 itself and cannot be used as an alternative to the financial reported standards applicable in the country. The IASB framework assists the IASB: ✓ Users of financial statements in interpreting the information contained in financial statements prepared in conformity with IFRS. ✓ Auditors in forming an opinion as to whether financial statements conform with IFRS ✓ Those who are interested in the work of IASB, providing them with information about its approach to the formulation of accounting standards. To ensure the framework provides useful information it identifies a range of user groups which include: investors, lenders, employees, suppliers, trade creditors, customers, government agencies; and the public. ELEMENT OF INTERNATIONAL ACCOUNTING STANDARDS BOARD (IASB) FRAMEWORKS The framework comprises seven sections of the following elements: ✓ Users of accounting information: The accounting information should portray the results of the stewardship of management or provides for the assembling of economic data and the communication of these data to the users for the users to be able to assess the accountability of the management which may influence the users’ decision making process. ✓ Informational needs of users: The users really need the accounting information to show corresponding information for preceding periods. The information should also be supplemented with notes and schedules to provide additional information relevant to the user. ✓ Kinds/Elements of financial statements: The elements of financial position of an entity are those which comprise the balance sheet: Assets, Liabilities and Equity. Those relative to financial performance comprise elements in the income statement: Revenues and Expenses. ✓ Characteristics of financial statements: The attributes that make information useful to the users include: understandability, relevance, reliability and comparability. Thus, the statement should understandable, relevant, reliable and comparable to the user group from on period to another. ✓ Recognition: It is the process of including in the financial statement an item that meets the definition of the element of financial statement and the financial recognition criteria. For the elements of financial statements to be recognized, an item must meet the fundamental recognition criteria; definition, measurability, relevance and reliability. ✓ Measurement: Once an item has been recognized, a decision has to be made as how it will be measured. To be included in the financial statements a monetary value must be DARKO KWANBENA EMMANUEL (DKE) & HARRISON KORBLA SETSOFIA (HKS) 15 UGBS 205: FUNDAMENTALS OF ACCOUNTING METHODS 07/14/2020 attached to it. The framework details a number of bases and these includes; historical cost, current cost, realizable (settlement value) and present value. GENERAL ACCEPTED ACCOUNTING PRINCIPLE (GAAP) GAAP is a cluster of usage of accounting standards and common industry usage that have been developed over many years. GAAP are set of rules that encompass the details, complexities, and legalities of business and corporate accounting. The Financial Accounting Standards Board (FASB) uses GAAP as the foundation for its comprehensive set of approved accounting methods and practices. It is used by organization to: ✓ Describe how financial statements are prepared in a given environment. ✓ Properly organize their financial information into accounting records. ✓ Summarize the accounting records into financial statements. ✓ Disclose certain supporting information. ACCOUNTING CONCEPTS AND COVENTIONS Although accounting is not an exact science, it is still governed by a set of principles, rules and customs which have been adopted as a general guide to the action of the accountancy profession. These are referred to as accounting concepts and conventions. ACCOUNTING CONCEPTS Accounting concepts are the broad basic assumptions that underline the preparation of periodic financial statements of a business entity. Thus, it is the assumptions which are used to prepare and disclose items in the financial statements. ACCOUNTING CONVENTIONS Accounting conventions are practices in accounting profession which have come to stay as a result of their continuous usage and conformity to established lines of thought. ACCOUNTING PRINCIPLES Accounting principles are the rules and guidelines that companies must follow when reporting financial data. These principles rest on the foundation of assumptions which establish boundaries of accounting process and serve as a cohesive force in the preparation of financial statements. ACCOUNTING POLICIES DARKO KWANBENA EMMANUEL (DKE) & HARRISON KORBLA SETSOFIA (HKS) 16 UGBS 205: FUNDAMENTALS OF ACCOUNTING METHODS 07/14/2020 Accounting policies are the specific principles and procedures implemented by a company’s management team that are used to prepare its financial statements. ACCOUNTING STANDARDS Accounting standards are authoritative standards for financial reporting and are the primary source of generally accepted accounting principles (GAAP). Accounting standards specify how transactions and other events are to be recognized, measured, presented and disclosed in financial statements. Accounting standards are common set of principles, standards and procedures that define the basis of financial accounting policies and practices. FUNDAMENTAL ACCOUNTING CONCEPTS There are numerous accounting concepts. However, SSAP’s disclosure of accounting policies considers four of them as fundamental which underline the preparation of periodic financial statements of the business enterprise. These are 1. GOING CONCERN CONCEPT This concept states that the business will continue to operate for a very long period of time. This means that the company will continue to operate for indefinite years or unforeseeable future. Significance ✓ It helps to take long-term loans. ✓ It helps to classify assets into fixed and current assets. ✓ It assumes that at least a business will be in existence till the end life of the assets. ✓ By this concept, assets are stated at their historical values, rather than their market value. Drawbacks/ Criticisms ✓ It may be misleading because some business entities cease operating immediately after the preparation of its accounts. ✓ Going concern value of assets of assets is usually unrealistic especially during inflation. 2. ACCRUAL OR MATCHING CONCEPT Under this concept, revenues and costs are recognized as they earned or incurred not as cash is received or paid. The revenues and costs are matched with one other so far as their relationship can be established and dealt with in the profit and loss account of the period which they relate. Significance DARKO KWANBENA EMMANUEL (DKE) & HARRISON KORBLA SETSOFIA (HKS) 17 UGBS 205: FUNDAMENTALS OF ACCOUNTING METHODS 07/14/2020 ✓ It is the reason for making year-end adjustments. ✓ It helps in determining the actual profit or loss for the period. ✓ It regulates the flow of accounting records to reflect the full transactions for the period whether paid or not. Drawbacks/ Criticisms ✓ It is difficult to determine which costs are associated with particular revenues. ✓ It is difficult to apportion expenses to time periods. ✓ The concept sometimes conflicts with prudence concept when for example recognized accrued revenue is never realized. 3. CONSISTENCY CONCEPT This concept states that once a method is chosen or used, it must be used regularly, continuous or throughout. For example, method of stock valuation includes FIFO (First-In-First Out), LIFO (Last-In-First Out), simple average and weighted average. What this concept is saying is that the business entity has the right to use any of these methods but if one is adopted, it should be followed consistently in the future. Significance ✓ It enhances management decisions. ✓ It enhances the objectivity of accounting results declared. ✓ It helps in the comparison of intra company results. ✓ It reduces subjectivity in accounting records and prevents manipulation of accounts. Drawbacks/ Criticisms ✓ Accounting recordings may lack dynamism if consistency concept is followed strictly. ✓ It prevents the accountant from using his/her initiatives to apply other methods that hi/her view might give better results. 4. PRUDENCE OR CONSERVITISM CONCEPT This concept states that the accountant should not anticipate for profit but rather anticipate for losses. Thus, if he is faced with two alternatives methods, he is advised to adopt the method which will make him show smaller profit. Significance ✓ It prevents a business entity from becoming insolvent. DARKO KWANBENA EMMANUEL (DKE) & HARRISON KORBLA SETSOFIA (HKS) 18 UGBS 205: FUNDAMENTALS OF ACCOUNTING METHODS 07/14/2020 ✓ It helps to make available enough funds for the payment of dividends and wages. ✓ It facilitates reliability on accounting information for decision making. Drawbacks ✓ It unnecessarily pessimistic ✓ The tendency to understate asset values to lower appropriate prices for shares on the stock exchange. OTHER ACCOUNTING CONCEPTS AND CONVENTIONS 1. BUSINESS ENTITY CONCEPT This concept state that the business is separated from the owner. For that matter, the business can be sue and be sued. This concept implies that the business should be seen as separate and distinct from its owner. On the basis of this concept, capital provided by the owner should be seen as a liability to the business and must be treated in the books as such. Significance ✓ It aims at drawing a distinction between a business and its owners. ✓ It satisfies legal requirements for the joint stock companies. ✓ It shows the correct performance and position of the business. ✓ Corporate tax is easily calculated. Drawbacks/ Criticisms ✓ It underlines the interest of the owner and the role the owner plays to promote his or her own business. ✓ The concept is artificial in that the assets and liabilities in law are that of the owner and not the artificial person “the business”. 2. HISTORICAL COST CONCEPT This concept states that all assets and expenses are recorded at cost or price at which the items were acquired. This means that items that have no cost should be recorded. Significance ✓ Historical cost concept is objective and verifiable. ✓ The historical cost gives avenue to apply the money measurement concept which is so fundamental to accounting. ✓ To maintain the going concern concept, assets should be recorded at their historical value not realizable value. Drawbacks/Criticisms DARKO KWANBENA EMMANUEL (DKE) & HARRISON KORBLA SETSOFIA (HKS) 19 UGBS 205: FUNDAMENTALS OF ACCOUNTING METHODS 07/14/2020 ✓ Items without cost are left out on accounts ✓ Historical cost values are irrelevant for making purposes. ✓ It conflicts with stock valuation principle which requires stocks to be valued at cost or net realizable. 3. MONEY MEASUREMENT CONCEPT This concept states that only items that can be measured in monetary terms should be recorded. It assumes that money acts as a common denominator for measurement of all transactions in the firm. Significance ✓ It shows the importance of money in business transactions. ✓ It shows the scope of accountancy. ✓ It makes it possible for business records to be audited. Drawbacks/ Criticisms ✓ Vital information which lack financial character is ignored. Example the competence of management, complaints of customers about company’s product etc. are not reflected in financial statements. ✓ Money as unit of measurement is unstable. Price level changes make money an unstable measuring tool. 4. PERIODICITY CONCEPT This concept assumes that financial statements must be prepared annually or yearly. Thus, the business set a time frame during which financial information in the form of final accounts must be prepared and reported to the appropriate users. Significance ✓ It helps in management forecasting and planning. ✓ It makes it compulsory for accountants to render accounts periodically. ✓ It feeds all users of accounting information of an organization with their needed information. 5. MATERIALITY CONCEPT This concept state that accountant should record items that are significant to the organization. The materiality depends on the size of the business. Insignificant are benefit put together. Information is material if its omission or misstatement could influence the economic decision of user of such information. Significance DARKO KWANBENA EMMANUEL (DKE) & HARRISON KORBLA SETSOFIA (HKS) 20 UGBS 205: FUNDAMENTALS OF ACCOUNTING METHODS 07/14/2020 ✓ It allows for easy comparison of intra company results because of the use of common denominator. ✓ It enhances objectivity in recording accounting transaction since the accountant is concerns mainly with transactions of monetary values. ✓ Without this concept there would be no accounting as monetary values are needed to prepare all the accounts. Drawbacks/ Criticisms ✓ Money as a unit of measurement is unstable. Price level changes make money an unstable measuring tool. 6. SUBSTANCE OVER FORM CONCEPT This concept states that transactions or events should be records in the financial statement based on the substance (whether paid or not) and not the legal form. For example, despite the fact that fixed assets under long term leases are not owned by the leasee (the user of the assets) they are account for as assets. This because the economic substance and financial reality is that the leassee has the right to the use of the asset and the right to use of the asset and this should be reflected in the accounts of the business. 7. DUALITY (DUAL ASPECT) CONCEPT This concept states that every accounting transaction should be recorded twice in the books of accounts. One at the debit side of the account and the other at the credit side of another account. This enables balance to be maintained in accounting equation. Assets = Capital + Liabilities The detailed application of this ensures that the balance sheet always balances. Significance ✓ It helps to check the arithmetical accuracy of the records. ✓ It makes the recording of accounting transaction complete. ✓ It upholds the double entry principle which is fundamental basis of recording accounting transaction. Drawbacks/ Criticisms ✓ It requires a lot paper work and much effort. ✓ Double entry system of bookkeeping is complicated, especially to the layman. EXAMINABLE QUESTIONS WITH SUGGESTED ANSWERS 1. In preparing the accounts of your company, you are faced with a number of problems. DARKO KWANBENA EMMANUEL (DKE) & HARRISON KORBLA SETSOFIA (HKS) 21 UGBS 205: FUNDAMENTALS OF ACCOUNTING METHODS 07/14/2020 a. The managing Director wishes the company’s good industrial relations to be reflected in the accounts. b. The long-term future success of the company is extremely uncertain. c. One of the owners of the company has invested his drawings in some stocks and shares. d. At the year-end, an amount is outstanding for electricity that has been consumed during the accounting period. e. All the fixed assets of the company would now cost a great deal more than they did when they were originally purchased. f. During the year, the company purchased $10 worth of pencils; these had all been issued from the stock and were still in used at the end of the year. g. The company has had a poor trading year, and the owners believes that more balanced result could be presented if a LIFO (last-in-first-out) stock valuation method was adopted, instead of the present FIFO (first-in-first-out) method. h. A debtor who owes a large amount to the company is rumored to be going into liquidation. i. The company owns some shares in quoted company, which the accountant thinks, are worthless. j. The company purchased furniture for $ 5000, the accountant records this transaction by debiting furniture’s A/C with the amount and crediting cash A/C with the amount. k. The business has purchased a machine on hire purchase business as this does not legally belong to the business so is known as a non-current asset in the balance sheet. You are required: i. State which accounting rule the accountant should follow in dealing with each of the above problems. ii. Explain briefly what each rule means. Suggested answer: a) Money Measurement Concept f) Materiality Concept b) Going Concern Concept g) Consistency Concept c) Business Entity Concept h) Conservatism (Prudence) Concept d) Accruals or Matching Concept i) Objectivity Concept e) Historical Cost Concept j) Duality Concept k) Substance Over Form Concept ii) Use the definition to explain DARKO KWANBENA EMMANUEL (DKE) & HARRISON KORBLA SETSOFIA (HKS) 22 UGBS 205: FUNDAMENTALS OF ACCOUNTING METHODS 07/14/2020 TUTORIAL QUESTIONS 1. What is conceptual framework? i. Differentiate between accounting concept and accounting principles. ii. State the major importance of the conceptual framework. 2. List seven accounting concepts and conventions. i. What is the significance of accounting concepts and conventions? ii. State two drawbacks of accounting concepts and conventions. 3. What is accounting concept? i. During the preparation of annual account of LET’S LEARN BUSSINESS ADMINISTRATION Ltd the accountant was faced with a number of concerns summarized as follows; a) A debtor who has heavily indebted to the company was rumoured to be going bankrupt. b) At 30th November 2019, an amount was due but unpaid for electricity and water that have been consumed during the accounting year. c) During the year, the company purchased GH¢ 3,500 worth of rubber bands. These were all issued from stock to the cashier and were still being used by him even at the end of the year. d) The company is defending in court, an action for damage due to alleged breach of contract. The company is likely to suffer pecuniary damages arising out of action. e) Due to prevailing factors, including economic, management realizes that the long run future prospects of the company are uncertain. f) Motor vehicles purchased by the company now cost more than when they were initially bought. g) The company’s chief executive wishes that the extremely cordial relationship existing between management and local union should be reflected in the books of accounts. h) An accounting statement should not be influenced by the personal bias of the person preparing it. i) The assumption that for reporting purposes the life of the enterprise can be divided into discrete period. Required: I. Name the accounting concept you would follow in dealing with each of the problems above. II. Explain the concepts identified in problems (a), (b), (f) and (g). “The master has failed more times than the beginner has even tried” DARKO KWANBENA EMMANUEL (DKE) & HARRISON KORBLA SETSOFIA (HKS) 23 UGBS 205: FUNDAMENTALS OF ACCOUNTING METHODS 07/14/2020 CHAPTER 3 THE ACCOUNTING EQUATION & RECOGNITION AND MEASUREMENT OF ELEMENTS OF FINANCIAL STATEMENTS NATURE OF ACCOUNTING EQUATION The principle and procedure of financial accounting is based on a simple equation know as accounting equation. This equation state that ASSET = CAPITAL + LIABILITIES. This can be explained by this simple scenario; assuming a business set up and resources are provided by the owner. The resources that are in the business are referred to as assets of the business while fund supplied by the owner is called capital (owner’s equity). This can be shown in equation as; ASSET = CAPITAL In some cases, the owner is not able to provide the resource alone and may result in borrowing from financial institutions and other people. When this happens, the business becomes indebted to such organizations or people. The indebtedness is known as liability in accounting. In this case the accounting equation will be; ASSETS = CAPITAL + LIABILITIES Illustration 1 On march 2006, D.K.E started boutique business by purchasing store building at GH¢ 4,000. The capital he stated the business with is GH¢ 4,000 and assets in the business are the store building which cost GH¢ 4,000. Therefore, this will be presented in the accounting equation as; Asset = Capital Store building = Capital GH¢ 4,000 = GH¢ 4,000 Illustration 2 Assuming D.K.E went in for loan GH¢ 2,000 and used it to purchase stocks in to his store. The accounting would be now shown as; Assets = Capital + Liabilities DARKO KWANBENA EMMANUEL (DKE) & HARRISON KORBLA SETSOFIA (HKS) 24 UGBS 205: FUNDAMENTALS OF ACCOUNTING METHODS 07/14/2020 (Store building + stocks) = capital + loan GH¢ 4,000 + GH¢ 2,000 = GH¢ 4,000 + GH¢ 2,000 GH¢ 6,000 = GH¢ 6,000 The relationship between assets, capital and liability can be expressed using the idea of change of subject. This has been shown below. Asset = capital + liabilities Assets – liabilities = capital Assets – capital = liabilities BASIC FINANCIAL ACCOUNTING TERMINOLOGIES ASSETS: Assets are resources controlled by the entity as a result of past events and from which future economic benefits are expected to flow into the business. They are the resources that belong to the business. Assets can be classified into two. These are non-current assets and current Assets. a. Fixed (Non-Current) Assets: These are durable properties acquired and retained by the business for purpose of earning income. These are assets acquired not for resale but to help in running the activities of a business entity or firm. In other word, fixed assets acquired for permanent use. Examples, Plants and Machinery, Land and Building, Fixtures and Fittings, Motor Vehicles and Business Premises. They are further divided into two: ✓ Tangible Fixed Asset: These are fixed assets that have physical existence. That is, they can be seen, feel and touch. Example include Land and Building, Furniture, Plant and Machinery, etc. ✓ Intangible Fixed Asset: These are fixed assets that cannot be represented by any physically represented. That is, they cannot be seen, feel and touch. Examples includes goodwill, copyright, patents right, trademarks, corporate images, etc. b. Current Assets: These are assets which are expected to be utilized in the business for short time. They are also called floating Assets. The benefits from current assets are derived within one accounting period and they are easily converted into cash. Examples includes stock, trade debtors, bank, income accrued, expenses prepaid, cash, etc. c. Liabilities: Liabilities are the entity’s financial obligation to transfer economic benefits as a result of past transaction or events. In other words, liabilities are form of Owings of the business to the outsider parties. Liabilities can be grouped into two. These are; DARKO KWANBENA EMMANUEL (DKE) & HARRISON KORBLA SETSOFIA (HKS) 25 UGBS 205: FUNDAMENTALS OF ACCOUNTING METHODS 07/14/2020 ✓ Long-term Liabilities: Long-term liabilities are liabilities that are payable beyond one accounting year. Examples includes debentures, long-term loans, etc. ✓ Current Liabilities: These are liabilities that are payable within one accounting period. Examples includes expenses accrued, trade creditors, bank overdraft, etc. d. Capital: Capital is the resources or funds supplied to a business by its owner(s), but have been transferred for the exclusive use of the business. This makes capital a liability to the business. in the other words, capital could be said to be any money used in starting a business. e. Revenue: It is the money generated from the day to day activities of the business. Revenue may also be seen as the benefit derived from investment. Examples are dividend received, interest received on loans or fixed deposit account, etc. f. Incomes: Income is increases in the economic benefits in the form of inflow of assets or decrease of liabilities that result in owner’s equity other than those relating to distribution to owners during accounting period. Examples includes rent received, discount received, commission received, etc. g. Expenses: expenses are decreases in economic benefits in the form of outflow of assets or increases in liabilities that results in decreases in owner’s equity other than those relating to distribution to the owner. Examples includes salaries, rent and rates, advertising, bad debts, provision for depreciation on Assets, etc. h. Reserves: this where an amount has been voluntarily set aside for specific purpose. With reserves, physical money or good are set aside. Examples of reserve include general reserve, capital reserve, foreign exchange reserve, etc. THE BALANCE SHEET Balance sheet is a statement which shows the financial position of a busines entity. It contains the Assets, capital and liabilities of the business entity. It reflects the accounting equation which state that; Asset = capital + liabilities DARKO KWANBENA EMMANUEL (DKE) & HARRISON KORBLA SETSOFIA (HKS) 26 UGBS 205: FUNDAMENTALS OF ACCOUNTING METHODS 07/14/2020 FORMAT OF THE BALANCE SHEET Balance sheet as at 31st December, 2008 Fixed Assets: GH¢ GH¢ Building xxx capital xxx Fixture and Fitting xxx add net profit xxx Motor Vehicle xxx xxx Current Assets: Less Drawings xxx Stock xxx xxx Debtors xxx Long-term liabilities Bank xxx loan xxx Cash xxx Current liabilities Creditors xxx xxx xxx BUSINESS TRANSACTIONS AND THEIR EFFECT ON ACCOUNTING EQUATION Any transactions that takes place in a business has either an increase or decrease effect on the accounting equation. Few transactions and their effects on the accounting equation are mentioned below; TRANSACTION EFFECT ON THE BALANCE SHEET When capital is introduced Liabilities will increase and Assets will increase This is because capital itself is a liability and the owner might have introduced it either by cash, bank or some other form of asset. When capital is reduced Liabilities will decrease and Assets will decrease Reducing capital means drawings of some kinds, this reduces the value of the capital and in reducing the capital, some cash or bank or other assets that has /have been taken from the business. When fixed Assets are bought for cash Assets will increase and Assets will decrease The fixed Asset bought has increased the value of DARKO KWANBENA EMMANUEL (DKE) & HARRISON KORBLA SETSOFIA (HKS) 27 UGBS 205: FUNDAMENTALS OF ACCOUNTING METHODS 07/14/2020 fixed Assets in the firm. The fixed Assets are paid for by cash, meaning a reduction of cash value. When fixed Assets are bought on credit Assets will increase and Liabilities will increase Whilst the value of fixed assets is increasing the creditor’s value will also increase. When fixed Assets are disposed off Assets will increase and Assets will decrease Fixed Assets will decrease by margin of the disposal and the amount received from the sales will also cause either the cash or the bank balances to increase. When expenses are incurred Assets will decrease and liabilities will decrease Paying for expenses will decrease the cash or bank balances and also decrease the net profit, which will in turn decrease in capital of the firm. When revenue is received Assets will increase and liabilities will increase Revenue receipts will increase the cash or bank balance and will also increase the net earnings, which will eventually increase the capital of the firm. When goods are sold for cash Assets will decrease and Assets will increase This decreases the available inventory/stock and increase the cash balance. When goods are sold on credit Assets will decrease and Assets will increase Inventory/stock decreases and receivables (debtors) increase. Both are Assets. When goods are bought for cash Assets will increase and Assets will decrease Cash decreases whilst stock (inventory) increases When goods are bought on credit Assets will increase and liabilities will increase Assets will increase due to the additions and Accounts payable (creditors) will also increase. When debtors settle their debts Assets will increase and Assets will decrease Cash/Bank will increase with equal decrease in the debtors’ balance. When bad debts are incurred Assets will decrease and liabilities will decrease Debtors’ balance will decrease, this will also decrease the profit potential which will in turn decrease the capital. When bad debt is recovered Assets will increase and liabilities will increase Debtors will be reinstated and earnings will also increase. When debtors are allowed discount Assets will decrease and liabilities is decrease Discount allowed decreases the debtor’s figure and increases expenses, which also decrease profits and therefore capital When some discount received Liabilities will decrease and liabilities will increase DARKO KWANBENA EMMANUEL (DKE) & HARRISON KORBLA SETSOFIA (HKS) 28 UGBS 205: FUNDAMENTALS OF ACCOUNTING METHODS 07/14/2020 Discount received decreases the creditor’s figure and also increase the earnings, which eventually increase the capital. When drawings are made Asset will decrease and liabilities will decrease Drawings decreases cash, bank, inventory (current Assets) or fixed Assets depending on what the proprietor(s) took out. This decreases the capital of the firm When profit is made by the firm Assets will increase and liabilities will decrease Profits increases the Assets base of the firm and also increases the capital. When cash is banked Assets will decrease and Assets will increase This decreases the cash in hand and increases the bank balance. When goods are withdrawn for private use Assets will decrease and liabilities will decrease Inventory (stock) decreases and capital also decreases When cash is withdrawn for business use Assets will decrease and Assets will increase Withdrawing cash from bank decreases the bank balance and increases the cash balances. RECONCILIATION OF TRANSACTIONS USING THE ACCOUNTING EQUATION It is very possible to use the accounting equation to reconcile transactions without necessarily using the ledger procedure. At the end of the day, the two sides of the equation will agree. Transactions involving nominal account items can conveniently be recorded in the balance sheet without having to prepare the profit and loss account. let us now use the illustration below to see how we can record a series of transactions and reconcile them using the accounting equation. Illustration 1 The following transactions relate to Harrison Setsofia, a sole proprietor on July, 2008. July 1 started business with cash GH¢ 2000. July 3 bought goods GH¢ 400 on credit from Ronaldo. July 9 contracted a loan of 700 and opened a current bank account. July 17 paid Ronaldo GH¢ 250 by cheque. July 21 sold good to Saforo on credit GH¢ 200. DARKO KWANBENA EMMANUEL (DKE) & HARRISON KORBLA SETSOFIA (HKS) 29 UGBS 205: FUNDAMENTALS OF ACCOUNTING METHODS 07/14/2020 July 25 bought fixtures and fittings GH¢ 300 with cash. July 28 cash received of GH¢ 100 from Saforo for goods sold. July 30 bought goods on credit from Desmond GH¢ 300. July 31 withdrew GH¢ 250 cash for private use. Solution Business transactions effect of transactions on Accounting Equation July 1 started business with cash GH¢ 2000 Increase capital (capital) Increase Assets (cash) July 3 bought goods GH¢ 400 on credit from Increase in liabilities Increase in Assets Ronaldo. (Creditors) (stock) July 9 contracted a loan of GH¢ 700 and Increase in liabilities Increase in Assets opened current bank account. ( loans) (Bank) July 17 paid Ronaldo GH¢ 250 cheque Decrease in liabilities Decrease in Assets (Creditors) (bank) July 21 sold goods to Saforo on credit GH¢200 Increase in Assets Decrease in Assets (Debtors) (stock) July 25 bought fixtures and fittings GH¢ 300 Increase in Assets Decrease in Assets with cash. (fixtures and fittings) (cash) July 28 cash received of GH¢100 from Saforo Increase in Assets Decrease in Assets for goods sold. (cash) (debtors) July 30 bought goods on credit from Desmond Increase in liabilities Increase in Assets GH¢300. (Creditors) (stock) July 31 withdrew GH¢250 cash for private use Decrease in Assets Decrease in Capital (cash) (Drawings) THE EFFECT OF ACCOUNTING EQUATION ON THE BALANCE SHEET Let see the effect of accounting equation on the balance sheet using the above illustration; DARKO KWANBENA EMMANUEL (DKE) & HARRISON KORBLA SETSOFIA (HKS) 30 UGBS 205: FUNDAMENTALS OF ACCOUNTING METHODS 07/14/2020 Assets = Capital + Liabilities Date Fixtures and Fittings stock Debtors Bank Cash Capital Loans Creditors GH¢ GH¢ GH¢ GH¢ GH¢ GH¢ GH¢ GH¢ July 1 +2,000 +2,000 July 3 +400 +400 July 9 +700 +700 July 17 -250 -250 July 21 -200 +200 July 25 +300 -300 July 28 -100 +100 July 30 +300 +300 July 31 -250 +250 300 500 100 450 1550 17,50 700 45 BALANCE SHEET (EXTRACT) Fixed Assets: GH¢ GH¢ Fixtures and Fittings 300 capital 1,750 Current Assets: Long-term liabilities: Stocks 500 Loan 700 Debtors 100 Current liabilities: Bank 450 Creditors 450 Cash 1,550 2,900 2,990 TUTORIAL QUESTIONS 1. (a) What is Accounting equation? (b) state the basic accounting equation. (c) the accounting equation is given by: A= L + E DARKO KWANBENA EMMANUEL (DKE) & HARRISON KORBLA SETSOFIA (HKS) 31 UGBS 205: FUNDAMENTALS OF ACCOUNTING METHODS 07/14/2020 i. Identify A, L and E ii. Why is A always equal to L + E? iii. Explain the relationship of the equation to balance sheet. 2. (a) distinguish between the following, giving examples in each case; (i) Fixed assets and current assets (ii) Long-term liabilities and current liabilities (iii) Revenues and expenses (b)explain the following terms as used in sole proprietorship type of business: i. Assets ii. Liabilities iii. Capital iv. Drawings ACCOUNTING PRACTICAL QUESTIONS 1. From the data below, fill in the gaps using the accounting equation to solve for them. Total Assets Total Liabilities Owner’s Equity GH¢ GH¢ GH¢ (i) ? 500 2,000 (ii) 1,500 ? 1,200 (iii) 1,200 250 ? (iv) ? 230 970 (v) 1,800 ? 1,500 (vi) 2,000 450 ? 2. Summarize the effects of each of these transactions on the accounting equation. (i) Started a business with GH¢200,000 cheque. (ii) Bought goods on credit worth GH¢50,000 from Afia. (iii) Contracted a loan of GH¢5,000 and opened a bank account. (iv) Payment of GH¢ 25,000 to Afia. (v) Payment of GH¢80,000 by cheque for office furniture. DARKO KWANBENA EMMANUEL (DKE) & HARRISON KORBLA SETSOFIA (HKS) 32 UGBS 205: FUNDAMENTALS OF ACCOUNTING METHODS 07/14/2020 (vi) A sale on credit of GH¢45,000 (vii) Cash purchases of GH¢18,000 (viii) Withdrew GH¢1,000 for private used from bank. 3. From the following information relating to the business of LET’S LEARN BUSINESS ADMINISTRATION Ltd, you are required to enter the transactions to reconcile the accounting equation and extract the balance sheet. June 2012: June 1 Started business with GH¢10,000 in the bank. June 4 Bought goods worth GH¢5,000 by cash and GH¢4,000 on credit June 7 Sold goods on account to Sammy GH¢790 June 15 Bought Machinery for cash GH¢1,000 June 20 Paid for administrative expenses GH¢650 June 22 Received a discount of GH¢50 from creditors. June 30 Obtained a loan facility from bank GH¢11,000 “Every beginner possesses a great potential to be an expert in his or her field” DARKO KWANBENA EMMANUEL (DKE) & HARRISON KORBLA SETSOFIA (HKS) 33 UGBS 205: FUNDAMENTALS OF ACCOUNTING METHODS 07/14/2020 CHAPTER 4 RECOGNITION AND MEASUREMENT OF ELEMENTS OF FINANCIAL STATEMENTS INTRODUCTION Recognition is the process of including in the financial statement an item that meets the definition of an element of financial statement and the fundamental recognition criteria. In other words, Recognition is the process of incorporating in the balance sheet or income statement an item that meets the definition of an element and satisfies the following criteria for recognition: It probable that any future economic benefit associated with the item will flow to or from the enterprise. The item’s cost or value can be measured with reliability. CHARACTERISTICS OF FUNDAMENTAL RECOGNITION CRITERIA For an element to be recognized in the financial statement, it must meet the fundamental recognition criteria; Definitions: the item which is going to be recognized, the item must meet the definition of an element of financial statements. Measurability: The item going to recognized must have a relevant attribute measurable with sufficient reliability. Relevance: the information about the item is capable of making a difference in user decisions. Reliability: the information about the item is representationally faithful, verifiable, and neutral. The general criteria for recognizing elements in financial statements is provided below: ❖ Assets: An Asset is recognized in the balance sheet when it is probable that the future economic benefits will flow to the entity and the Asset has a cost or value that can be measured reliably. The economic benefits contribute, directly or indirectly, in the form of cash or cash equivalents. Even though many Assets are in physical form, such as machinery, the physical form is not essentials. For example, patents and intellectual property are Assets controlled by the entity and have future economic benefits. ❖ Liabilities: A liability is recognized in the balance sheet when it is probable that an outflow of resources embodying economic benefits will obligation and the amount at DARKO KWANBENA EMMANUEL (DKE) & HARRISON KORBLA SETSOFIA (HKS) 34 UGBS 205: FUNDAMENTALS OF ACCOUNTING METHODS 07/14/2020 which the settlement will take place can be measured reliably. For example, account payables are present obligations, which will result in an outflow of resources embodying economic benefits. ❖ Incomes: Income is recognized in the income statement when an increase in future economic benefits related to an increase in as Asset or a decrease of a liability has arisen that can be measured reliably. In effect, the recognition of income occurs simultaneously with the recognition of increase in assets or decreases in liabilities. For example, when sale is made, it results in a net increase in assets (cash). Income includes both revenues and gains, such as from sale of assets that are not a part of the normal business activity. ❖ Expenses: Expenses are recognized when a decrease in future economic benefits related to decrease in an asset or an increase of a liability has arisen that can be measured reliably. In effect, the recognition of expenses occurs simultaneously with the recognition of an increase in liabilities or a decrease in assets. For example, the depreciation of an asset decreases the asset and the expense is recognized. Expenses includes both expenses and losses. MEASUREMENT OF ELEMENTS IN FINANCIAL STATEMENTS Measurement is defined as putting monetary amount on an element of financial statement. In other words, Measurement is the process of determining the monetary amounts at which the elements of the financial statements are to be recognized and carried in the balance sheet and income statement. This involves the selection of the particular basis of measurement. A number of different measurement bases are employed to different degrees an in varying combinations in financial statements. They include the following: ❖ Historical cost: Assets are recorded at the amount of cash or cash equivalents paid or the fair value of the consideration given to acquire them at the time of their acquisition. That is, they are based on acquisition cost or the original cost of the item. ❖ Current (replacement) value: Assets are carried at the amount of cash or cash equivalents that would have to be paid if the same or an equivalent asset was acquired currently. That is, they are based on the cost that will be incurred in acquiring a similar item on the market in its current state. ❖ Net realizable (statement) value: Assets are carried at the amount of cash or cash equivalents that could currently be obtained by selling the asset in an orderly disposal. DARKO KWANBENA EMMANUEL (DKE) & HARRISON KORBLA SETSOFIA (HKS) 35 UGBS 205: FUNDAMENTALS OF ACCOUNTING METHODS 07/14/2020 That is, they are based on the net amount that would be realized in the event of disposing off the item. ❖ Present (discounted) value: Assets are carried at the present discounted value of the future net cash flows that the item is expected to generate in normal course of business. That is, they are based on the discounted future cash flows associated with usage of the item. TUTORIAL QUESTIONS 1. State the difference between recognition and measurement of element. 2. (a) write how the following items or elements are been recognized in accounting. i. Income ii. Expenses iii. Asset iv. Liabilities 3. State and explain any three of the bases of measurement of element. 4. Define the following terms: (a) Recognition of elements in financial statement (b) Measurement of elements in financial statement “Never judge your full potential based on your first run” DARKO KWANBENA EMMANUEL (DKE) & HARRISON KORBLA SETSOFIA (HKS) 36 UGBS 205: FUNDAMENTALS OF ACCOUNTING METHODS 07/14/2020 CHAPTER 5 DOUBLE ENTRY PRINCIPLES INTRODUCTION The double entry bookkeeping is the system which involves recording each transaction twice. The double entry rule for accounts is referred to as the Golden rule of accounts. It is the basis upon which all transactions are recorded in the ledger. This rule state that; “For every debit entry, there must be a corresponding credit entry and for every credit entry, there must be a debit entry”. That is for every transaction, two recording should be made – one at the debit side and the other at the credit side. This means that after each transaction the sum of the debit side should be the same as the sum of the credit. It implies if the double entry principle is followed to the end then, the trial balance should balance. This system of bookkeeping was propounded by an Italian Monk known as Fra Luca Pacioli who was also a mathematician. This entry principle is based on Duality Concept. BUSINESS TRANSACTIONS Business transaction is a micro piece of business activity. Business transaction are transactions engaged by the firm which can be quantified in monetary terms. We call recall in the definition of accounting that what are recorded in the books of Account are transactions and events of at least a financial character. However, every business transaction involves two things: inflow and outflow of goods, services or money. The inflow is the receiving of goods, services or money and the outflow is the giveaway of goods, services or money. Therefore, every business transaction involves exchange which occurs simultaneously – the giving of something and the receiving of something. For example, when business enterprise sells goods to customer for cash, in the point of view of the business, goods are given away (outflow of goods) and cash is received (inflow). In other hand, if the business buys goods for cash. The two things that happen in this transaction are inflow (receipts of goods) and outflow (give away) of money. These two things that happened are recorded in the books of account based on the double entry principle. ADVANTAGES OF DOUBLE ENTRY SYSTEM(TRAMP) ✓ It gives the true picture of the financial obligations and the resources of a business organization. ✓ A complete recording of transaction is made. ✓ It checks the arithmetical accuracy of the clerical work. ✓ It provides the means of monitoring day to day activities of the business organization. DARKO KWANBENA EMMANUEL (DKE) & HARRISON KORBLA SETSOFIA (HKS) 37 UGBS 205: FUNDAMENTALS OF ACCOUNTING METHODS 07/14/2020 ✓ It facilitates the preparation of financial statements. THE MEANING AND TYPES OF LEDGER The ledger is the principal book of accounting. The ledger contains the accounts or records of a business entity and it’s kept on the double entry principle, the golden rule of accounting which states that “every debit entry must have a corresponding credit entry and every credit entry must have a corresponding debit entry”. All pages of the ledger are ruled in the same way. A page of a ledger is divided into two equal sides. The left side is called debit and the right side is called credit. Below is the format of a page of a ledger; Title of the Account Date particular folio Amount Date particular folio Amount GH¢ GH¢ The ledger is sometimes known as the final resting-place of all accounting records. The ledger is divided into the following types: ❖ Sales/Debtors ledger: It is the book used for keeping records of all debtors of a business entity. It an example of a personal ledger. It should be noted that it should not be used for keeping sales account. ❖ Purchases/Creditors ledger: It is the book for keeping records of all creditors of firm. It is also an example of a personal ledger. It should not be used for keeping purchase account. ❖ General/Nominal ledger: This is the book that contains only the real and the nominal accounts of an entity. Examples, motor vehicle account, rent account, stock account, sales account, purchase account, etc. ❖ Private ledger: Private ledger is the book that contains records of transactions relating to the proprietor of an entity. Examples of such account include capital account and drawings account. ❖ Cash book: It is a book of an account which keeps bank and cash transactions of the firm. THE MEANING AND CLASSIFICATION OF ACCOUNT An account is the record, in a summarized form, of all transactions that affect a particular type of assets, liabilities or owners’ equity. It is simply the records of a ledger. It is the form by which bookkeepers and accountants record the additions and subtractions of financial events in a ledger. DARKO KWANBENA EMMANUEL (DKE) & HARRISON KORBLA SETSOFIA (HKS) 38 UGBS 205: FUNDAMENTALS OF ACCOUNTING METHODS 07/14/2020 Features of an Account (i) It is represented by the letter ‘T’ and abbreviated as A/C. (ii) It has a title written on top of the ‘T’. (iii)The left side of the account is termed ‘debit side’ and the right side is termed ‘the credit side’. The nature of an account Let us now look how an account is presented. An account is presented below; Title of the Account DEBIT (DR) CREDIT (CR) Date particular Amount Date particular Amount Example D.K.E A/C May 2010 GH¢ May 2010 GH¢ 1 Sales A/C 20,000 23 Purchases A/C 10,000 TYPES / CLASSIFICATION OF ACCOUNT Accounts are broadly classified into two; Personal account and Impersonal account. Personal account are accounts opened in the names of persons, firms, and other artificial persons such as institutions who may be either debtors or creditors to the business. Thus, these are accounts used to record transactions relating to persons and the business entity. Examples, debtors, creditors and capital, etc. Impersonal account are accounts used to record transactions other than those relating to persons and the business entity. Impersonal accounts are further classified into real account and nominal account. ✓ Real accounts: They are accounts used for recording tangible items such as Land and Building account, Plant and Equipment account, Fixtures and Fittings account, Motor Vehicle account etc. ✓ Nominal account: They are account used for recording items which do not have physical existence. These are items may be expenses, losses, gains and incomes. Examples of nominal account includes wages and salaries A/C, rent and rate A/C, discount received A/C, discount allowed A/C, sales A/C, purchases A/C, etc. DARKO KWANBENA EMMANUEL (DKE) & HARRISON KORBLA SETSOFIA (HKS) 39 UGBS 205: FUNDAMENTALS OF ACCOUNTING METHODS 07/14/2020 Personal Accounts and Real Accounts balances are used for the preparation of the balance sheet while Nominal Accounts balances are used for the preparation of the Profit or Loss Account. Students are encouraged to have an in-depth knowledge of double entry to enable them enjoy the study of accounting. This is because the whole of accounting is based on this principle. DOUBLE ENTRY RULE FOR ACCOUNTS We look at what constitutes an account and how accounts are classified. Each of these classifications will have its own double-entry rule to apply. Let us look at each of the classified accounts and the double entry that applies: 1. PERSONAL ACCOUNTS - Debit the person receiving and - Credit the person giving. Remember here that, when we talk about giving and receiving, we mean the principle item being or received. It may be money or assets or some other items that have monetary value. 2. IMPERSONAL ACCOUNTS a. Real Accounts: - Debit incoming Assets or increasing in value of Assets. That is, if an asset is acquired, the said asset account is debited. If the asset is already in the business but new ones have been added, the asset account should also be debited with the new ones. - Credit Outgoing Assets or Decreasing in values of Assets. An outgoing asset is an asset being disposed off through sale or discard. b. Nominal Accounts: - Debit Expenses and Losses. This means that the moment an expense is incurred, whether payments have been affected or not, the Expenses Account must be debited. - Credit Revenue, Gains, Income and Profit, Revenue as studied earlier refers to all forms of receipts accruing to the firm for services rendered or goods sold. Revenue received takes the form of assets especially cash and bank. Since the cash or bank being received will be debited, then it is very logical that the revenue takes the corresponding entry, i.e. credit. DARKO KWANBENA EMMANUEL (DKE) & HARRISON KORBLA SETSOFIA (HKS) 40 UGBS 205: FUNDAMENTALS OF ACCOUNTING METHODS 07/14/2020 DOUBLE ENTRY RECORDING FOR SOME COMMON TRANSACTIONS TRANSACTION DOUBLE ENTRY RECORDING When cash is used to start a business Dr. Cash A/C Cr. Capital A/C When fixed asset is bought for cash Dr. Fixed Asset A/C Cr. Cash A/C When goods are bought for resale for cash Dr. Purchase A/C (Cash purchase) Cr. Cash A/C When goods are bought for resale on credit Dr. Purchases A/C Cr. Creditors A/C When goods are sold for cash (cash sales) Dr. Cash A/C Cr. Sales A/C When goods are sold on credit Dr. Debtor’s A/C Cr. Sales A/C When cash is received from debtors Dr. cash A/C Cr. Debtor’s A/C When debtors settle their debits by cheques Dr. bank A/C Cr. Debtor’s A/C When cash is deposited in the bank Dr. bank A/C Cr. Cash A/C When expenses are paid for by cash Dr. Expenses A/C Cr. Cash A/C When expenses are paid for by cheque Dr. Expenses A/C Cr. Bank A/C When creditors are settled Dr. Creditors A/C (either by cash or cheque) Cr. Cash or Bank A/C When cash/ cheque is withdrawn for personal use. Dr. Drawings A/C Cr. Cash or Bank A/C DARKO KWANBENA EMMANUEL (DKE) & HARRISON KORBLA SETSOFIA (HKS) 41 UGBS 205: FUNDAMENTALS OF ACCOUNTING METHODS 07/14/2020 ILLUSTRATIONS The transactions below are related to Darko Emmanuel is a sole proprietor in the month of April 2008. i) 1 Started business with GH¢200,000 cash. ii) 4 Bought machinery for cash GH¢100,000 iii) 8 Purchases GH¢50,000 cash. iv) 12 Rent paid by cheque GH¢2,000 v) 16 Sold goods on credit to Philip GH¢10,000 vi) 20 Sold goods for cash GH¢80,000 vii) 24 Received a cheque for GH¢10,000 from Philip Required: Enter the above transactions in their appropriate accounts. Suggested answer: IN THE BOOKS OF DARKO EMMANUEL (i) The two accounts in this statement are: Dr. Cash A/C Cr. Capital A/C Cash Account Capital Account April GH¢ April GH¢ April GH¢ April GH¢ 1 Capital 200,000 1 Cash 200,000 (ii) The two accounts in this statement are: Dr. Machinery A/C Cr. Cash A/C Machinery Account Cash Account April GH¢ April GH¢ April GH¢ April GH¢ 4 Cash 100,000 4 Machinery 100,000 (iii) The two accounts here are: Dr. Purchases A/C Cr. Cash A/C DARKO KWANBENA EMMANUEL (DKE) & HARRISON KORBLA SETSOFIA (HKS) 42 UGBS 205: FUNDAMENTALS OF ACCOUNTING METHODS 07/14/2020 Purchases Account Cash Account April GH¢ April GH¢ April GH¢ April GH¢ 8 Cash 50,000 8 Purchases 50,000 (iv) The two accounts here are: Dr. Rent A/C Cr. Bank A/C Rent Account Bank Account April GH¢ April GH¢ April GH¢ April GH¢ 12 Bank 2,000 12 Rent 2,000 (v) The two accounts are: Dr. Philip A/C Cr. Sales A/C Philip Account Sales Account April GH¢ April GH¢ April GH¢ April GH¢ 16 Sales 10,000 16 Philips 10,000 (vi) The two accounts are; Dr. Cash A/C Cr. Sales A/C Cash Account Sales Account April GH¢ April GH¢ April GH¢ April GH¢ 20 Sales 80,000 20 Cash 80,000 (vii) The two accounts are: Dr. Bank A/C Cr. Philips A/C Bank Account Philips Account April GH¢ April GH¢ April GH¢ April GH¢ 24 Philips 40,000 24 Bank 40,000 DARKO KWANBENA EMMANUEL (DKE) & HARRISON KORBLA SETSOFIA (HKS) 43 UGBS 205: FUNDAMENTALS OF ACCOUNTING METHODS 07/14/2020 In bookkeeping an account is not opened twice within the same accounting period. If an account had been opened earlier, all additional information about the particular account should be entered in the existing account. For instance, all those accounts that were opened more than once should have been one. Eg. The Cash A/C should have been: Cash Account April GH¢ April GH¢ 1 Capital 200,000 4 Machinery 100,000 20 Sales 80,000 8 Purchases 50,000 Fig 1.2 DOUBLE ENTRY FOR RETURNS INWARDS, RETURNS OUTWARDS, EXPENSES AND REVENUE Return Inwards: This is where goods sold by the business entity are return due to defect, fault etc. This is also called sales returns. When goods are return to the business entity: The accounting treatment is Dr. Return Inwards/Sales Returns Account Cr. Debtors Account Return Outwards: This is where the business entity returns the goods bought for resale to the creditor because of defects, faults etc. This is also called purchase returns. When the business entity returns goods to suppliers, the accounting treatment is Dr. Creditors Account Cr. Return Outwards Account. Expenses: Expense is an expenditure incurred in carrying out day to day activities of the business organization. Examples include rent, rates, wages & salaries, electricity, insurance, advertising etc. When Expenses are paid by cheque or cash, the accounting treatment is: Dr. Expenses Account Cr. Bank/Cash Account. Revenue: Revenue is the money realized by a way of rendering service or from sale of goods or assets. Examples include rent received, commission received etc. When revenue is received by cheque or cash, the accounting treatment is: Dr. Bank/Cash Account Cr. Revenue Account. BALANCING OFF ACCOUNTS A business once established, must be seen as going into the foreseeable future; unless it was established to last for defined period of time. It must be possible to have all full details of an item of account for as long as the business is in existence. This is done by adding balances of previous period to current balances in order to ascertain total balances for the account. DARKO KWANBENA EMMANUEL (DKE) & HARRISON KORBLA SETSOFIA (HKS) 44 UGBS 205: FUNDAMENTALS OF ACCOUNTING METHODS 07/14/2020 An account is balanced by finding the totals of both sides of the account and ascertaining the difference between the totals. The difference is called the ‘balance of the accounting’. STEPS TO BALANCE AN ACCOUNT ▪ Enter the transaction in the appropriate ledgers using the appropriate double entry procedure. ▪ Find the totals of both sides of each account at the end of the period. ▪ Find the difference between the two sides of each account. ▪ Add the difference to the side with the lower total and name it as ‘balanced carried down; balance c/d’ ▪ Rule a single line on both sides of the account under the balance c/d. ▪ Enter the totals; which are now equal, on the same line of both sides of the account and underline it twice. ▪ Enter the balance c/d under the double line in the opposite side and name it as ‘balance brought down; balance b/d’. Note: The balance c/d and the balance b/d are the same figure with one on the opposite side of the other. Where the balance b/d is at the debit side of the account, the account is said to have a debit balance and vice versa. The balance c/d should bear the last date of the period and the balance b/d should bear the first date of the next period. Example: Using the illustration in the previous chapter fig 1.2: CASH ACCOUNT April GH¢ April GH¢ 1 Capital 200,000 4 Machinery 100,000 20 Sales 80,000 8 Purchases 50,000 31 31 Balance c/d 130,000. 280,000 280,000 Balance b/d 13,000 DARKO KWANBENA EMMANUEL (DKE) & HARRISON KORBLA SETSOFIA (HKS) 45 UGBS 205: FUNDAMENTALS OF ACCOUNTING METHODS 07/14/2020 DEBIT AND CREDIT BALANCE OF AN ACCOUNT These are terms used to describe the balances obtained on the accounts. Debit balance: This obtained when total amount at the debit side of an account is greater than the total amount at the credit side of the account. In this case the balance brought down (balance b/d) is at the debit side. Credit balance: This obtained when the total amount at the credit side of an account is greater that the total amount at the debit side of the account. In this case the brought down (balance b/d) is at the credit side. Illustration Aboagye Mensah started business on June 1st, 2009 with a capital GH¢14